Income generated from virtual worlds is still taxable in the real world

People who make money on Pokemon Go! or other virtual games might catch a tax bill with the IRS

By: Mohitindervir Sandhu / September 23, 2016

When the original Pokemon came out in 1996, not many people would have guessed that Pikachu, Squirtle, Charmander, and Bulbasaur would one day become relatively well-known words.

Or that people of all ages would be running around in public trying to catch Pokemon with their smart phones, in augmented reality.

Or that some players would find a way to make real-world dollars from these hundreds of little creatures.

Sometimes, real life can be stranger than fiction. But one reality simply cannot be augmented: If players are generating income from Pokemon Go! and other games, they’ll have to pay taxes on it.

When the real and the virtual meet, taxes happen

Getting paid for a virtual gaming side gig is not a new phenomenon. It’s been going on for years in many virtual universes.

Many of these online virtual worlds are known as massively multiplayer online role-playing games (MMORPGs). Up to millions of players move their characters to higher levels in the game (called “leveling up”), by defeating powerful monsters and completing quests to collect rare items. As they level up, players can also receive virtual in-game currency for their efforts.

If virtual currency and real-world money don’t interact, the IRS will have no income to tax. But actions in virtual worlds can impact taxes in the real world. Here are some common examples.

Selling rare items and characters

In many MMORPGs, individuals play for dozens of hours to complete difficult quests or slay hard-to-find monsters to obtain rare items. Just like the real-world laws of economics, scarcity of a resource coupled with high demand means there’s a sale to be had.

When players sell rare items to another player for real-world currency, the sale generates taxable income. In a similar scenario, players with advanced and powerful in-game characters may sell the characters for a taxable profit. In either case, since the player is selling personal property, the sale proceeds will be taxed as a short-term or long-term capital gains.

Working as outsourced help

Sometimes players don’t have time to invest in leveling up their characters and developing advanced skills, so they hire someone else to complete the tasks.

Just like a job in the real world, if an individual is getting paid to slay orcs, nazguls, or dragons for someone else, that individual will be taxed on the earned income. These players must follow the tax rules for determining whether they are earning the income as employees, independent contractors, or hobbyists.

Hobby or business activity?

For people making money outside of a traditional full-time job, the hobby-loss area of tax law may apply. These rules limit the expenses that taxpayers can deduct when they are participating in a hobby, versus a business activity that they expect will make a profit.

Determining profit motive can be complex and sometimes confusing. There are nine factors to consider for properly determining whether an activity is a business or a hobby.

Selling virtual currency in the real world

Some people play online games to amass large amounts of virtual gold. Normally, gold or other virtual currencies are important only in the game itself. This is because players can use the gold to buy more powerful weapons, magic, and armor to fight stronger monsters and advance in the game.

But some players sell virtual gold for real-world money. This is about scarcity of time. A player may have plenty of real-world disposable income, but little time to play the game to build his character to more advanced levels. So, the player will make a deal with another player who has time to “farm gold” by performing repetitive tasks in the game.

All of this may seem unreal and even slightly humorous. But in the real world, it represents a multibillion dollar industry that capitalizes on interactions in the virtual world.

Taxing Pokemon Go!

Players are also taking advantage of the income-generating potential of Pokemon Go! Here are several tax effects that dedicated Pokemon Go! users and their advisors should consider now and for the future:

Selling a Pokemon Go! account. This transaction would generate taxable income on a taxpayer’s federal tax return. The seller would also have to check to see whether his or her state would tax the income, as well. Some states are considering a digital-download tax (i.e., a sales tax) that may tax Pokemon Go! at the state level.

Trading Pokemon. An important component of the original games was the ability to trade Pokemon between players. This would be a taxable bartering transaction in the eyes of the IRS if any real-world money is exchanged.

Walking and driving in the real world. Some players are getting paid to perform tasks related to Pokemon Go!, such as walking to “hatch” eggs for other players, or driving players to certain locations. This all represents earned income. Each set of facts and circumstances would determine whether the individual earned the income as an independent contractor, an employee, or a hobbyist. The answer will determine the tax treatment.

Looking ahead. In the future, Pokemon Go! creators could allow players to sell their Pokemon to another player, or introduce rare items into the mix. These will all be taxable transactions if real-world money is exchanged.

Businesses. If taxpayers develop a business around money they make from Pokemon Go!, they’ll have to file accordingly for that, too. For example, the owner of a sole proprietorship would report the income and expenses on Schedule C, and may have to pay self-employment tax. The same rules that apply to businesses generating income in the real-world also apply to businesses generating income from virtual worlds.

There are sure to be many other creative ways people will find to make money from Pokemon Go!. Ultimately, the tax code will categorize each type of income as ordinary income or capital gains, and then tax it accordingly.

In the end, players should remember that the Pikachu they love so dearly can have an impact in the real world. The same tax principles that have applied since before the dawn of the virtual world will continue to apply today and in the future.

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Mohitindervir Sandhu

Mohitindervir Sandhu, JD, EA, is a senior tax research analyst at The Tax Institute. Mohitindervir leads a research team focused on international tax issues.